WeeklyBasis 08/13/07: How the Credit Crisis Affects Jumbo Loans

This week, the rate spread between Conforming loans (up to $417k) and Jumbo loans (above $417k) remains much larger than normal. Conforming loan rates are pricing to markets as normal because these loans are still marketable in secondary markets; most are sold to government-backed entities. Jumbo loan rates are pricing not to market but to their level of risk – and they’re much more risky right now because when lenders go to sell Jumbo loans, traditional buyers like investment banks, pensions, and hedge/mutual funds aren’t buying. This is why Jumbo pricing and approval guidelines are so much tighter in the last 10 days. Normally, my WeeklyBasis report is 2 paragraphs on how the week’s economic data will affect rates and noteworthy lending issues for the week. But since lending issues are still front page news and much of our market is Jumbo, I am again expanding WeeklyBasis to explain how this is playing out and when it might end.

UPDATE ON APPROVAL GUIDELINES
The rate markets currently suggest that Jumbo rates should be .5% to 1% lower than they are. But lenders are using risk-based pricing (as opposed to market pricing) to slow the flow of loans and tighter approval guidelines to make new loans more attractive to investors. Tighter guidelines are primarily focused on Stated Income rules and Loan-To-Value ratios. Please note there are exceptions to the guidelines below which I can explain on a case-by-case basis. Also I am not quoting deals or providing estimates to Realtors without talking to clients first.

Stated Income Jumbos are now require minimum 700 FICOs and at least 6 months’ stated income verified in the bank AFTER down payment. Straight wage-earners are extremely unlikely to get stated income loans. They must be commissioned, heavily bonused, or self-employed, and we don’t know how how long this category of stated will last. As for LTV guidelines, 80/10/10 deals will still fly for full doc borrowers with good credit and 6 months in reservesin the bank after their 10% down. But if it’s stated income, the cheaper option for many profiles is a single 90% loan with mortgage insurance. Stated income/stated asset loans are off the table, and any deals (involving Jumbo loans) with less than 10% down are also extremely difficult.

PROBLEMS GO WAY BEYOND SUB-PRIME
The two biggest concerns for Jumbo lenders right now are: (1) who will buy their loans, and (2) how to make sure loans are marketable. The marketability question is easier to answer. If the loans are made to strong borrowers who are good credit risks, the loans are marketable because groups of those loans will comprise marketable bond portfolios that can be traded in global markets.

The question of who will buy Jumbo loans is harder to answer because the investment banks, pensions, hedge/mutual funds and other organizations that would normally buy are still on the hook for existing pipelines of mortgage-backed securities that they can’t move anywhere in the global financial system. Nobody wants these securities because, now that investors are finally looking at the underlying pools of loans that comprise these securities, they are seeing that many are backed by loans in default or loans likely to go into default.

If investors can’t move their existing mortgage-backed pipelines, they can’t buy new better quality debt even if they wanted to. On the loan origination end, tighter guidelines will definitely create a new wave of good quality loans that investors will buy, securitize and trade. And on the securitization end, eventually the pipelines of bad debt will be flushed out (see ‘Fed’s Role’ below). But the huge question is when, and nobody knows.

FED’S ROLE IN A CREDIT CRISIS
The role of central banks, including the Fed, goes beyond interest rate policy. They can also provide liquidity to global markets when everything freezes up like it has. When the Fed kept rates steady after their meeting last Tuesday, many thought they were crazy. But they kept their position that higher rates will prevent the inflation that comes from an economy that’s growing too fast.

Instead of raising rates, they contributed about $62 billion since last week to purchase mortgage-backed securities that nobody else would buy. The European and Japanese central banks also contributed about $300 billion to the cause. This has helped holders of these securities get some of this bad debt off their books and given confidence to the markets, but in the context of all outstanding mortgage debt, $362 billion isn’t much. Between 2004 and 2006, the time when lender guidelines were flimsiest, about 14 million families purchased homes at an average cost of $250,000. Even in conservative scenarios, that 2 year pool alone could contain at least 10 times more than the $100 billion of bad sub-prime debt Ben Bernanke estimated just 3 weeks ago.

This Tuesday and Wednesday the Fed will get their latest reads on manufacturing and consumer inflation, and if these numbers are benign, maybe we will also see them supplement their cash contributions with a rate cut – the remaining 2007 Fed meetings are on September 18, October 31, and December 11.

WHAT IT MEANS FOR BAY AREA
It’s certainly going to take more than a few hundred billion to solve the global credit problems. Looking forward from now to the end of 2008, there is another 1.2 trillion in mortgages set to adjust upward by 1-2%. This puts lots of pressure on homeowners, and if they can’t meet their obligations, it puts pressure on values. Defaulted loans on homes that are declining in value would in turn put more pressure on the financial system than we have already seen.

As existing damages unwind over the next 12-36 months, tighter lending guidelines will be creating new pools of loans that financial institutions will definitely want to buy and hold or securitize. It’s just going to mean fewer buyers get qualified so the new pipeline takes longer to replace the existing pipeline of bad debt. And here in the Bay Area, there’s a lot less property supply and more high paying jobs than there is in other U.S. markets, so we shouldn’t see quite the same decline in demand even as borrowers drop out because of qualification issues.